Right now, in emergency teleconferences all around the world, boards and management teams are abruptly reassessing a question – what is the appropriate capital structure for our business? Debt is no longer efficient. It is bad. Equity used to be called expensive. Now it’s good and safe.
Whether this new attitude is long lasting will depend on the business recovery, the actions of central banks and governments and the responses of markets. Many of us who lived through the financial crisis thought it would leave a lasting and permanent mark on attitudes to debt, much as the Great Depression did 75 years earlier. It didn’t.
But there’s no doubting the short-term reappraisal. And it’s happening at businesses both strong and weak.
A spectrum would be more accurate, but it’s mentally useful to think about the coming rash of equity raisings as falling into one of two baskets. Those going on the front foot from a position of strength, and those doing it to survive.
Wednesday, UK car classifieds business Auto Trader (LSE:AUTO) raised cash from shareholders. It expanded its equity capital 5% by issuing new shares at a 9% discount to the prior day’s closing price. Our international portfolio has a few stocks we consider almost bullet proof, Auto Trader is one.
The company won’t generate any revenue in April and minimal revenue for at least a few months afterwards. It faces a long grind back to normalcy thereafter.
But this doesn’t threaten the business. The first 70p in every pound the company isn’t currently charging customers is merely giving up its very fat profit margin. Of the other 30p, the overwhelming majority is staff costs. The UK’s very generous furloughing policy means that much of the expense of paying unneeded staff is being borne by the government. Auto Trader is topping up any shortfalls so that nobody gets a pay cut (good policy in my opinion). But overall costs are falling sharply.
The group had little debt going into the crisis, and the ability to draw on a credit facility if needed. And yet, it raised equity – enough to clear most of its remaining debt and, in the words of the press release, let the company “take advantage of future opportunities”. It’s the very definition of raising from a position of strength.
The recent raising by hearing implants business Cochlear (ASX:COH) belongs in the same basket. Unlike Auto Trader, Cochlear may need some immediate cash, having lost a patent infringement case for US$268m that will now go to appeal. But with its impressive balance sheet it could have found a friendly banker to cover it. Instead, it chose to raise equity, expanding its share count 10% by issuing shares at a 17% discount to the last traded price.
Fight for survival
For businesses like Auto Trader and Cochlear, a few months of drastically reduced revenue means a bad quarter or year. There are other businesses, though, that are immediately imperilled by any shut down. Their business model simply wasn’t built for it, quite understandably.
Low margin, high fixed-cost businesses such as retailers, travel agents and airlines come easily to mind. And pretty much any company with high debt prior to the crisis now has what’s considered an unacceptable debt load. By the time this is over, they’ll have come to market for cash or they’ll likely have gone bust.
Travel seller Webjet has been massively impacted by the crisis. It raised its share count 150% by issuing shares on Wednesday at a 57% discount to the last trade price.
The same day, outdoor gear retailer Kathmandu also pulled the trigger, offering a 51% discount to increase its share count 140%.
Note the dramatic discounts to get these issues away. A useful rule of thumb is that the more equity a company needs (as a percentage of its existing market capitalisation) and the more urgently it needs it, the bigger the discount the market will demand.
It’s expensive, foul tasting medicine for the company as well as any shareholder unable to participate. But if you’re going to panic, panic early. Those that take longer to realise they need capital may find the going tougher. That’s how it played out in the financial crisis at least.
Our funds aim to be liquidity providers, for the right price. We’ve already participated in both types of raisings – strong hand, small discount and weak hand, big discount. Both can be a source of opportunity, but the latter is a richer set. We’ve developed lists of companies likely to need to raise in the months ahead, worked out in what circumstances we would choose to participate, and bought small stakes in several companies in order to (hopefully) gain preferential treatment afforded to existing shareholders. We’ve contacted brokers and companies directly, letting them know to give us a call if the time comes. We’re ready to go.
Retail shareholders won’t be getting a call when companies need cash in a hurry. No Accelerated Bookbuild or Institutional Entitlement Offer for you. But you’ll often get an even better opportunity – the Retail Entitlement Offer or Share Purchase Plan.
Both represent an attempt to treat retail shareholders fairly. Sometimes, particularly due to scale backs, that attempt will fail. But, sometimes, you’ll get a better deal than institutions.
Take Kathmandu’s offering. Announced at 9am on 1 April, institutions had 12 hours to decide and commit to buying more shares at NZ$0.50. Retail shareholders get offered the same 1.2 new shares for every 1 they currently hold, at the same price, under its retail entitlement offer. But they have more than two weeks to commit and pay. Two weeks is a long time in the current market, making that optionality valuable.
Trading in Kathmandu shares has reopened and they last traded at A$0.815, so there’s likely a very fat, low risk arbitrage profit there for the taking. And you have a few weeks to find a way to fund it, perhaps by selling some of your existing position. But if the stock tanks anytime in the next two weeks, you can keep your money or buy stock on the market at a cheaper price than institutions paid in this raising.
Webjet retail shareholders have a similar opportunity, although they get an even longer 3 weeks to decide whether to invest.
The Cochlear offer for retail shareholders, structured as a Share Purchase Plan, will likely prove less fair. All retail shareholders, regardless of the size of their investment, are offered “up to” $30,000 worth of shares at the same $140 price paid by institutions. But the company is only seeking to raise $50m this way, so investors are subject to scale back and are unlikely to get a full $30,000.
Advantageous, fair or otherwise, there will be many such offers to consider in the weeks and months ahead. Best put some forethought into it. And don’t leave any free money on the table.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.